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In the first moments of 2013, Congress eased the fiscal cliff tax increases for taxpayers earning less than $450,000 by enacting the American Taxpayer Relief Act (Act), permanently extending the Bush-era income tax cuts for this group (President Obama signed the Act into law on Jan. 2).
While the legislation extends the current income tax rates for taxpayers earning less than $450,000 ($400,000 for single filers) per year, it allowed the Bush-era tax cuts to expire for all higher-income taxpayers. Similarly, taxes on capital gains, dividends and estates were increased for the wealthiest taxpayers. Though widespread tax hikes were avoided, all taxpayers should expect to see at least slightly higher taxes in 2013 because both parties agreed to allow the 2% payroll tax cut to expire effective Jan. 1.
The Cliff Compromise Part 1: Income Taxes
The Act essentially prevented tax increases for most taxpayers by extending the Bush-era tax rates for taxpayers earning under $450,000 annually for joint filers, $425,000 for heads of households, $400,000 for singles and $225,000 for marrieds filing separately. Tax rates will rise for individual taxpayers earning those new amounts from 35% to 39.6%. At the most basic level, this will increase the income tax burden for a single taxpayer earning $400,000 annually by about $18,400 per year.
Although the marginal income tax rates were increased only for the wealthiest taxpayers, the expiration of the payroll tax cuts increased the tax burden for all taxpayers effective Jan. 1. The payroll tax cuts, which were put into place in 2011 and later extended through 2012, reduced the 6.2% Social Security payroll tax on wages by 2%. This tax cut was allowed to expire at the end of 2012, resulting in an increase in taxes for all wage earners. The tax applies to the first $113,700 of an employee’s wage income for 2013.
Now that the payroll tax cuts have expired, the average American worker earning $50,000 per year will pay approximately $80 per month more in taxes—and high-income employees will see an increase of up to $2,200 per month, on top of the increases in their marginal income tax burden.
The Cliff Compromise Pt. 2: Tax Deductions and Exemptions
Under 2012 law, taxpayers who itemized deductions were allowed a variety of tax deductions—including deductions for mortgage interest, charitable contributions, and state and local taxes—that effectively reduced their income tax burden. In 2012, there was no phaseout of itemized deductions based on AGI, which allowed all taxpayers to deduct larger amounts, thereby reducing taxable income.
Prior to 2010, most itemized deductions were reduced dollar-for-dollar by the lesser of
- 3% of the amount of the taxpayer’s AGI that exceeded $166,800, as adjusted annually for inflation ($83,400 for married taxpayers filing separately) or
- 80% of the amount of such itemized deductions otherwise allowable for the tax year.
In 2005, changes to the tax code implemented a provision that gradually reduced the limitation on itemized deductions until it was eventually repealed for 2010-2012. Despite this, this reduction was temporary and was scheduled to expire at the end of 2012—when the limitations on itemized deductions would resume beginning Jan. 1, 2013.
Because the phaseout was allowed to resume in 2013, upper-middle-class and high-net-worth clients who have earned income above the annual threshold levels are limited in the itemized deductions that they are allowed to recognize. The phaseout will begin at $250,000 for single individual taxpayers and $300,000 for married couples filing jointly and surviving spouses. The phaseout results in a substantially higher tax burden for these taxpayers—in addition to the increase in the marginal tax rates agreed upon for this group.
Also, for 2013, the personal exemption phaseout, which had also been suspended, is reinstated, with a threshold for those making $300,000 for joint filers and a surviving spouse; $275,000 for heads of household; $250,000 for single filers; and $150,000 for married taxpayers filing separately. The total amount of exemptions that can be claimed subject to the limitation is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer's adjusted gross income exceeds the applicable threshold.
Fiscal Cliff Compromise Pt. 3: Capital Gains and Dividends
Like the income tax rates, the favorable tax rates applicable to capital gains and dividends were part of a compromise agreement set to expire at the end of 2012. Under the Act now signed into law, Congress increased the capital gains and dividend tax rates for individual taxpayers earning over $400,000 annually and married couples earning over $450,000, but prevented large increases on this income for lower-income taxpayers.
Under 2012 law, investments held for more than one year (long-term capital gains) were taxed at a maximum rate of 15% for taxpayers in the 25% tax bracket or higher. Taxpayers in the 10% and 15% tax brackets were taxed at 0% on long-term gains recognized in 2012. Similarly to capital gains taxes, dividends were taxed at 0% for taxpayers in the 10% and 15% tax brackets in 2012; taxpayers in higher brackets paid a 15% tax on dividend income.
Prior to the Bush-era tax cuts, capital gains were taxed at 15% or 20%, respectively. Dividend income, however, was taxed as ordinary income, meaning that taxpayers in the highest tax brackets could be taxed nearly 40% on this income.
Congress prevented these substantial increases in the American Taxpayer Relief Act so that dividend income continues to be taxed in the same manner as income from capital gains. For taxpayers who fall within the new 39.6% tax bracket, the 15% rate was increased to 20% effective Jan. 1. When coupled with the new investment income tax (discussed below), the capital gains and dividend rates will rise to 23.8% for high-income taxpayers. Taxpayers who are taxed below 25% will be taxed at 0% on capital gains and dividends, and the 15% capital gains and dividends rate will continue to apply to taxpayers taxed at higher than 25%, but who earn less than the $450,000 ($400,000 for single filers) income threshold. The additional 3.8% tax on net investment income applies as well to arrive at 18.8%.
Fiscal Cliff Compromise Pt. 4: Estate and Gift Tax Rates
In 2012, the maximum estate and gift tax rate was 35% for taxpayers who were not able to shelter their entire estate through the generous $5.12 million exemption. These rates were reached through a series of phased-in reductions in the tax rate and increases in the exemption amount. However, like most of the other tax cuts implemented during the Bush-era, these rates were set to expire effective Jan. 1, 2013, when tax rates would revert to pre-2001 levels. Had the estate tax provisions been allowed to expire, the top tax rate would have reverted to 55% with an exemption level of only $1 million.
The new Act sets the top estate and gift tax rate at 40%, and the exemption was fixed at $5 million as of Jan. 1. As under 2012 law, the $5 million exemption will continue to be indexed annually for inflation. The estate and gift taxes will remain unified, so that the $5 million exemption also applies for gift tax purposes.
Further, the deal continues the estate tax portability provisions that allow a surviving spouse to automatically take advantage of his or her deceased spouse’s unused exemption amount. This provision allows a surviving spouse to avoid complicated estate planning by recognizing that gifts between spouses are typically tax-free, and allowing the exemption to be portable between both spouses.
Because the exemption level will permanently remain at its generous 2012 level and will remain portable between spouses, estate planning will be simplified for most families. Even those high-income taxpayers who expect to leave estates in excess of $5 million can plan with certainty.
Fiscal Cliff Compromise Pt. 5: AMT and Credits
The new American Taxpayer Relief Act also:
- Provides a permanent Alternative Minimum Tax patch by increasing exemption amounts and allowing individuals to offset AMT liability with nonrefundable personal credits,
- Extends the American Opportunity Tax Credit as well as many other deductions and exclusions,
- Continues many business tax breaks, such as employment-related and energy-related credits.
Beyond the Act: Investment Income Tax
Separate from the American Taxpayer Relief Act, an additional 3.8% tax on the investment income earned by certain higher-income taxpayers was added as part of the Patient Protection and Affordable Care Act (PPACA, aka Obamacare). Under the PPACA, this additional tax becomes effective for gains realized on or after Jan. 1, 2013. Though this tax was not a part of the fiscal cliff negotiations, it will result in a tax increase for many investors.
The 3.8% tax on “unearned income” will affect taxpayers with adjusted gross income (“AGI”) of more than $200,000 for single filers or $250,000 for married couples filing jointly.
This 3.8% will be added to the rates currently in effect, increasing the capital gains and dividend tax rates from 20% to 23.8% in 2013 for the wealthiest taxpayers.
Though the tax is deemed to be a tax on unearned investment income, in some circumstances it can apply to a portion of a taxpayers’ AGI. In calculating the tax owed, the taxpayer must first determine his or her net investment income for the year. If net investment income is less than the amount by which the taxpayer’s AGI exceeds the $200,000/$250,000 threshold, the tax applies to the investment income. If net investment income is greater than the difference between AGI and the threshold amount, the tax applies to the portion of AGI that exceeds the threshold.
Therefore, if a married couple has $300,000 of earnings in 2013, the tax applies to all investment income, but if the couple has $225,000 in earnings and $100,000 in investment income, the tax applies only to the $75,000 because the first $25,000 falls below the $250,000 threshold.
So What Is 'Investment Income'?
Essentially, net investment income is income that is considered “unearned”—meaning income received from investments such as stocks, bonds or mutual funds. Net investment income obviously includes dividends and interest received through investment in these vehicles, but can also apply to income derived from a trust or, in some cases, the sale of a primary residence.
To determine whether the tax applies to the sale of a primary residence, special rules apply. A single taxpayer is permitted to exclude the first $250,000 of capital gain from his or her AGI (the amount is increased to $500,000 for a married couple filing jointly). So, for example, if a married couple purchased a home for $100,000 and later sells it for $700,000, their capital gain is $600,000. The couple would then subtract the $500,000 exclusion and add the $100,000 excess to their AGI. There is no exclusion for a secondary residence.
Amounts received from Social Security, 401(k) plans, IRAs, pensions and similar retirement income is not included in net investment income, though these types of income could still increase AGI above the threshold levels.
Planning Under the Act: How Should Clients Plan for Higher Taxes in 2013?
Though Congress acted to prevent higher taxes for many taxpayers, high-net-worth clients will experience higher taxes in 2013 and beyond. With proper planning, some of this tax burden can be alleviated.
Clients who will become subject to the additional investment income tax can move some of their investments to minimize the impact of the tax. For example, income from municipal bonds is currently exempt from the tax. Gains realized on investments in retirement accounts are also not subject to the additional 3.8% tax and, in many cases, contributions to these accounts can be made with pre-tax dollars that can reduce a client’s AGI to below the threshold income levels that trigger the tax.
Higher taxes will also make life insurance a much more attractive investment vehicle in 2013 and beyond. The Act, coupled with the new tax on investment income, has resulted in a substantial tax increase on income received from traditional investments. Because of this, many clients will be looking for ways to realize gain on investments without the corresponding tax burden.
While the primary purpose of life insurance is to provide income for an insured’s beneficiaries upon his or her death, certain types of life insurance policies can also function as tax-preferred investment vehicles.
Life insurance policies that provide coverage for an insured’s entire life will likely become a more attractive product for clients looking to minimize the tax burden on their investment portfolios. This type of permanent life insurance policy is one that remains in effect for the client’s entire life, so long as they continue paying the premiums. While these policies are more expensive than term life insurance, they are guaranteed to provide a death benefit as long as the policy is maintained.
In addition to the guaranteed death benefit, permanent life insurance policies allow the policyholder to accumulate cash in the policy that can be withdrawn tax-free in the future. Much like a Roth IRA, the growth realized on the cash value of the policy is not subject to tax, making these policies a powerful savings vehicle for clients who have already maxed out their contributions to traditional retirement accounts. The longer a client can afford to allow the investment in the product to grow, the greater the investment return that can be realized. Therefore, these products are best suited for long-term investors who have pulled their investments from the equity markets because of the increased capital gains rates.
Whole life policies are a type of permanent life insurance with these investment benefits. At its most basic level, a whole life insurance policy requires that an investor pay a level premium each year and provides for a guaranteed death benefit on the death of the insured. However, these policies also contain an investment component, which is why they can provide a viable alternative for long-term investors. A portion of the premiums paid are invested by the life insurance company issuing the policy, building cash value in the policy that the insured can borrow against. As noted above, premiums may have to be paid into the policy for a long period—sometimes 15 to 20 years—before substantial appreciation on the investment can be seen.
While withdrawals against the cash value of these policies are taken tax-free, they reduce the death benefits payable to the insured’s beneficiaries. Further, withdrawals are sometimes taxable—the individual policy should be examined to determine whether the withdrawal is taxable—any withdrawal that exceeds the taxpayer’s basis in the policy will be subject to income taxation.
In some cases, if the withdrawal is for more than the policy’s cash surrender value, the insurer can also increase the premiums required to maintain the same death benefit under the policy. A substantial increase could cause the policyholder to have trouble meeting premium payments—in which case the policy would lapse and the investment could be lost.
While Congress acted to prevent widespread tax increases for most taxpayers, the reality is that even lower-income taxpayers will see at least slightly higher taxes in 2013. High-income and small-business-owner clients will see the most pronounced increases and will want to take even stronger steps to plan for these changes in 2013.
We invite you to visit the AdvisorOne Fiscal Cliff landing page for up-to-date coverage on the fiscal cliff negotiations and the implications of going over the cliff.
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